Adam Smith, widely regarded as the founder of economics, made significant contributions to our understanding of market dynamics and economic order. However, he did not get everything right. One of his most notable inaccuracies, shared by many economists of the 18th and 19th centuries, including Karl Marx, is his flawed theory of value and price determination.
Smith adhered to the “labor theory of value” (LTV), which posits that the value (and price) of goods is derived from the labor invested in their production. This theory is often expanded to include other production costs, forming what is known as the “cost of production theory.” The central error in Smith’s approach—and that of his contemporaries—is the notion that the value of outputs is strictly determined by the inputs involved in their creation. In modern economics, this idea has been discarded. Value is now understood to be rooted in the subjective assessments individuals make regarding how well specific goods and services fulfill their desires. This subjective and marginalist perspective emerged in the 1870s, transforming our understanding of value much like Copernicus revolutionized our view of the solar system. We now understand that goods hold value because consumers find them useful, not merely because of the labor expended to create them. In this article, we’ll explore Smith’s views and then discuss the modern theory of value, highlighting its advantages over the labor theory.
In The Wealth of Nations, Smith is straightforward about his belief that labor is the primary source of value. For instance, in Chapter 5, he states:
The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labor which it enables him to purchase or command. Labor, therefore, is the real measure of the exchangeable value of all commodities.
Later in the same chapter, he asserts:
Labor alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price.
Smith acknowledges the complexities introduced by money, noting that not all labor is equal—that is, the skills and competencies of workers vary, making it difficult to assess the value of labor solely by hours worked. He suggests that these disparities are balanced through the “higgling and bargaining of the market.” Nevertheless, he remains adamant that labor is the fundamental and “real” measure of value.
Throughout the chapter, Smith contrasts the “real” value of goods—determined by labor—with their “nominal” price, mediated through money. In a barter economy, goods might trade more easily at ratios reflecting the labor required to produce them, as illustrated by Smith’s well-known deer and beaver example. However, in a market where money predominates, the price we see is merely an estimate of value derived from labor. He argues that while nominal prices can fluctuate, labor’s inherent value remains consistent and is the underlying force that shapes the value of all goods and services.
Smith and other classical economists considered the concept of utility when discussing value. Their struggle to reconcile labor as the source of value with the “water-diamond paradox”—whereby water, essential for life, is cheap and diamonds, a luxury, are expensive—exposed limitations in their understanding. If use value were determined by utility, this discrepancy was troubling. The classical economists grappled with this issue, which ultimately confounded economists like Marx as well. Consequently, they faced challenges in accurately explaining value and price.
These challenges were addressed in the 1870s by economists such as William Stanley Jevons, Leon Walras, and Carl Menger, who discovered variations of the same critical insight: value is determined “on the margin.” This Marginal Revolution in Economics shifted the focus from the total supply of a good to the specific unit considered for exchange at any given moment. This understanding resolves the water-diamond paradox by emphasizing that value is derived not from total utility but from marginal utility—the contribution of the specific unit available for purchase.
For example, given that the marginal piece of water (a bottle) represents a tiny fraction of the total, it holds less value compared to diamonds, which are scarcer. Here, the concept of “thinking on the margin” fundamentally reshaped economic thought. Making decisions based on additional benefits and costs—those specifically related to the moment—became a crucial aspect of economic decision-making. For instance, when a student considers skipping a class, the evaluation hinges on the value of that specific hour, not the overall worth of the education itself. Therefore, the focus on marginal utility underscores that value is contingent upon the specific circumstances of consumer choice.
This explanation reinforces that marginal benefits and costs do not correlate to the labor involved. In fact, the notion of “marginal thinking” intersects with what is known as the “subjective theory of value.” Throughout the 19th century, some thinkers began to appreciate that value is not defined solely by production costs, including labor, but instead by how individuals perceive that specific goods will fulfill their desires. However, these early discussions were incomplete until Jevons, Walras, and Menger added their insights, fully marrying marginal concepts with subjectivity.
Interestingly, one cannot grasp the significance of marginal thinking in value theory without acknowledging subjectivism. This becomes particularly evident in Carl Menger’s work, which, while sharing common ground with his contemporaries, offered a unique perspective. Menger articulated the value concept without relying on mathematical frameworks, which differentiated his theory. Menger stressed that goods derive their value from our perception of their ability to satisfy our desires. He contended that “economic” goods—those we desire yet cannot have in ample supply—exhibit value distinct from “non-economic” goods.
Menger emphasizes in his Principles of Economics that value is not an intrinsic property of goods, nor is it an independent entity. Instead, it is a judgment made by individuals about the significance of available goods for fulfilling their needs. Thus, value only exists within human consciousness and is affected by subjective interpretations. He summarizes this idea succinctly:
Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being.
Menger’s viewpoint reflects both subjectivity and marginalism: value hinges on our perceptions and the concrete quantities of goods at hand—not their total stock. For him, value stems from the belief that specific quantities can satisfy particular human needs. This principle applies to real-world scenarios. For example, if someone has two gallon buckets of water, their value fluctuates based on their intended use—a clear illustration of how specific, concrete instances determine perceived value.
Understanding diminishing marginal utility is also essential here. As individuals acquire additional buckets of water, their importance often declines, impacting how much one is willing to pay for each subsequent unit. This fundamental principle underpins the modern downward-sloping demand curve.
In summary, the contrast between modern subjectivism, marginalism, and the labor theory of value is now clear. The latter looks backward to production costs, while the former focuses on how value is shaped by our beliefs about a good’s future ability to meet our needs. As consumers, not producers, we ultimately ascribe value. The labor theory suggests value is infused by production, but Menger argues this perspective is flawed. It is irrelevant whether a diamond is found or painstakingly mined—value arises from consumer perception, not from the labor expended in its creation.
This marginalist revolution can be likened to Copernicus’s heliocentric model, shifting our understanding of value in economics. For earlier economists like Smith, the value of inputs dictated the value of outputs. In contrast, after the 1870s, this relationship reversed. Our focus shifted to the goods that satisfy wants. These desired end products inherently have value, which subsequently assigns worth to the inputs involved in their production. Labor doesn’t imbue goods with value; it is the value consumers place on goods that renders labor valuable. Thus, value flows from the output to the input, not the opposite. The chef’s valued labor arises from the meal’s perceived worth, not the other way around.
This article was first published at AdamSmithWorks, part of the Liberty Fund network. For further insights into the Labor Theory of Value, consider Eric Schliesser’s piece, Smith’s Labor Theory Thought Experiment.
